Payment types and number of franchisees

Abstract

Current studies of the franchise system usually assume that the number of franchisees is exogenous and irrelevant to the payment types. However, to a franchise system or a franchiser the optimal number of franchisees is related to the payment types, e.g., franchise fee, royalty, etc. We develop a game-theoretical model and then use 1998 Bond's Franchise Guide Data for US franchise stores in order to test the theoretical predictions. According to our theoretical predictions, the optimal number of franchisees under a royalty is strictly less than that under a franchise fee. This is because royalties distort the effort incentive of franchisees and the franchiser can increase average revenue by having a smaller number of franchisees. A franchise fee will not distort the effort incentive of franchisees and can help achieve a higher profit for both the franchiser and the franchise system. When demand is certain, the optimal royalty rate to the franchise system is zero. Under a royalty payment, the royalty rate will be greater than zero if the franchiser maximises its own profit. Empirical results support our theoretical predictions: there is no significant relationship between franchise fee and number of franchisees. The number of franchisees has a significantly negative relationship with royalties, while it is significantly and positively correlated with the experience of the franchise system, area, training, and advertising fees required by the franchiser.